July 6, 2023
Welcome to our ultimate guide on exit cap rates in real estate investing. With the continuous fluctuations and complexities inherent in real estate markets, it is crucial to understand all the intricacies of your investment strategy. One such pivotal aspect is the exit capitalization rate, or 'exit cap rate', which is a key determinant of potential returns from a real estate investment. In this comprehensive guide, we will demystify exit cap rates, illustrating how they are calculated, their influence on investment profitability, and how to effectively use them in your strategic planning.
Since your exit cap rate is such a major assumption in any real estate financial model, I wanted to take a deep dive into the topic.
In this blog post I plan to cover the following:
With that as our guide, let’s dive in!
Let’s start by defining a number of the buzzwords in real estate to make sure we are all on the same page.
What is a capitalization rate in real estate?
In real estate, the capitalization rate, often referred to as the "cap rate", is a ratio used to estimate the potential return on an investment property. It is calculated by dividing the property's net operating income (NOI) by its current market value. The NOI is the revenue from the property minus the operating expenses, not including any mortgage payments or other financing costs.
Mathematically, it looks like this:
Cap Rate = Net Operating Income / Current Market Value
So, for instance, if a property generates $10,000 per year in net income and its market value is $100,000, then the cap rate would be 10%.
The cap rate provides a useful tool for comparing potential investment properties. A higher cap rate often implies higher risk but also higher potential returns, while a lower cap rate can suggest less risk and steadier, but often lower, returns. However, it's important to remember that like all metrics, the cap rate should not be used in isolation but in conjunction with other measures and considerations to evaluate a real estate investment fully.
Cap rate vs. capitalization rate
The terms "cap rate" and "capitalization rate" refer to the same concept in real estate investment analysis. They are often used interchangeably. Both terms describe a ratio used to estimate the potential return on a real estate investment.
The capitalization rate (or cap rate) is calculated by dividing a property's net operating income by its current market value. The resulting figure, expressed as a percentage, gives investors an estimate of their potential return on an investment property, assuming they purchased the property outright (i.e., without a mortgage).
In short, when you hear someone talking about the "cap rate" or the "capitalization rate", they are referring to the same measure of investment potential in the real estate world.
What is an exit cap rate?
An exit cap rate, also known as a terminal cap rate or reversion cap rate, is an estimation of a property's future net operating income (NOI) divided by its expected selling price at the time of sale. It's a concept used in real estate investment to help estimate the value of a property at the end of the investment period, typically a number of years in the future.
It's important to note that the exit cap rate is generally assumed to be higher than the initial cap rate, which accounts for the increased risk over time, including factors like market volatility, changes in property condition, and economic fluctuations. This difference can also account for potential changes in market conditions, where a market might become less desirable over time, impacting property values.
For example, if an investor buys a property with a cap rate of 5% but anticipates that the market conditions could be less favorable when they plan to sell in five years, they might assume an exit cap rate of 6%. This figure would then be used to estimate the future selling price based on their projected net operating income at that time.
Like all estimations, the exit cap rate is not a guaranteed prediction but a planning tool that can help guide investment decisions and strategies. It's vital to reassess this figure periodically as market conditions change.
Terminal cap rate vs. exit cap rate
In the context of real estate investing, a terminal cap rate and an exit cap rate are the same thing. They both refer to the anticipated capitalization rate at the point of selling an investment property, typically several years in the future.
Just to reiterate, the terminal or exit cap rate is used to estimate the future selling price of a property. This is calculated by dividing the property's projected net operating income (NOI) at the time of sale by the assumed terminal/exit cap rate.
What is a going in cap rate?
A "going in cap rate", also known as an "entry cap rate" or "initial cap rate", is the projected first-year capitalization rate of a real estate investment. Essentially, it's the ratio of the net operating income (NOI) expected in the first year of operation to the purchase price of the property.
Mathematically, it can be represented as:
Going In Cap Rate = Year 1 Net Operating Income / Purchase Price
For instance, if an investor buys a property for $1,000,000 and expects to generate a net operating income of $70,000 in the first year, then the going-in cap rate would be 7%.
The going-in cap rate is a crucial figure for investors because it provides an initial snapshot of the property's potential yield or return.
An exit cap rate, also known as a terminal cap rate, is not something that is typically calculated using a formula, but rather it's an assumption or estimate made by a real estate investor based on their analysis of market trends and other risk factors.
While the initial or "going-in" cap rate is calculated based on the property's current net operating income (NOI) and purchase price, the exit cap rate is what the investor estimates the cap rate to be when the property is sold at the end of the investment horizon.
Investors usually project an exit cap rate that is higher than the initial cap rate to account for the increased risk and uncertainty over time. The assumption of a higher exit cap rate reflects potential changes in market conditions, the economic environment, or the property’s condition that could impact its value and income generation potential.
Here is how an exit cap rate is used to estimate the property's future sale price:
Future Sale Price = Projected NOI at Sale / Exit Cap Rate
So, if an investor is projecting a net operating income of $120,000 at the end of a 5-year investment period and they assume an exit cap rate of 6%, the estimated future sale price of the property would be $2,000,000.
Determining what constitutes a "good" exit cap rate in real estate is largely subjective and depends on a variety of factors, including the investor's individual risk tolerance, the specific property and its location, the state of the market, the economic environment, and the investor's specific financial goals.
Typically, a higher exit cap rate indicates a higher level of risk and potential return, while a lower cap rate might suggest a safer, but potentially less profitable, investment. It's not unusual for an investor to assume an exit cap rate that's higher than the property's initial cap rate to account for potential changes in market conditions and the risk of holding the property over time.
As a rule of thumb, many investors might add a 1% - 2% premium to the going-in cap rate to estimate the exit cap rate. So if the initial cap rate was 5%, the exit cap rate might be projected as 6% - 7%. But this is only a general guideline and doesn't replace a thorough analysis of market trends and other risk factors.
Keep in mind that projecting an exit cap rate involves making assumptions about future market conditions, so there's always a level of uncertainty involved. Consequently, it's wise for investors to consider multiple scenarios with different exit cap rates when planning their investment strategy to ensure they're prepared for a range of potential outcomes.
Although we can’t know exactly what exit cap rates will be for various real estate asset classes in the future, we can look at the past as a guide. Statista provided the following historic and forecasted cap rates for the real estate industry:
Based on the Statista cap rate forecast, you could use the following exit cap rates for properties selling in 2023 and 2024.
The terminal cap rate, also known as the exit cap rate, significantly influences the Internal Rate of Return (IRR) on a real estate investment. The IRR is the annual rate of growth an investment is expected to generate, and in the context of real estate, it considers the initial purchase price, the net cash flow from the property during the holding period, and the sale price of the property at the end of the investment term.
The terminal cap rate is used to estimate this future sale price. The estimated future sale price is determined by dividing the projected net operating income (NOI) in the sale year by the assumed terminal cap rate.
If the terminal cap rate is higher than the initial cap rate (a common assumption to account for increased risk over time), it implies a lower estimated sale price for the property. Conversely, if the terminal cap rate is lower than the initial cap rate, it suggests a higher future selling price.
Given that the future sale price directly impacts the cash inflow in the calculation of IRR, a lower terminal cap rate (resulting in a higher estimated sale price) would increase the IRR, assuming all else remains constant. Conversely, a higher terminal cap rate (implying a lower future sale price) would result in a lower IRR.
Example of how cap rate impacts IRR
Using one of our Real Estate Pro Forma Templates I can demonstrate just how much of an impact a small change in the cap rate can have on the IRR of a property. Let’s assume that we have a multifamily apartment complex with an exit cap rate of 6% that yields an IRR of 14.23% as seen below:
A small change in the exit cap rate down to 5% and the IRR increases to 17.99% and the sale proceeds increased by roughly $6 million!
So we can see that this is just a major assumption and over the last couple of years there has been a significant increase in cap rates from historic lows which means that property values should decrease materially.
So what exit cap rate should you use when creating your real estate pro forma? Since this is such a major assumption, you want to be careful with how you forecast an exit cap rate. There are a couple of approaches you could take.
- Add 1% to 2% to your Entry Cap Rate - this is likely a conservative approach that assumes the cap rate will increase by the time you are ready to sell the property.
- Use your most recent appraisal - When you get an appraisal for your property you can take your current net operating income and divide by the appraisal value to calculate the cap rate for the current valuation. You could use this as a starting point for your financial model.
Improving the exit cap rate on a property actually involves reducing it, since a lower exit cap rate could result in a higher property sale price. This could potentially increase your return on investment when you sell.
Here are a few strategies to potentially improve (reduce) your exit cap rate:
Increase Net Operating Income (NOI): The NOI is the annual revenue generated by the property minus the operating expenses. If you can increase your rental income, reduce vacancies, or decrease operating expenses, you will increase your NOI, and therefore potentially reduce your exit cap rate.
Property Upgrades and Maintenance: Regularly maintaining and upgrading the property can enhance its value, make it more attractive to tenants (thereby increasing occupancy rates and income), and potentially reduce your exit cap rate.
Location & Market Trends: Properties in desirable locations or high-growth areas often command lower cap rates due to their perceived lower risk and greater potential for appreciation. Staying informed about market trends and economic indicators in your area can help you anticipate shifts that might affect your exit cap rate.
Long-Term Leases: Securing long-term leases with reliable tenants can stabilize your rental income, reduce vacancy risk, and make your property more appealing to future investors, which could lead to a lower exit cap rate.
Financial Structure: By optimizing the financial structure of the deal (e.g., securing favorable financing terms), you can potentially improve the overall return, which might positively affect the exit cap rate.
Remember that these strategies do not guarantee a lower exit cap rate, as market conditions, economic trends, and other factors also play significant roles. However, they can certainly increase the appeal and financial performance of your property, making it potentially more attractive to buyers and potentially leading to a lower exit cap rate when you sell.
I hope this article has been helpful as you consider your exit cap rate assumptions. If you have any questions at all please don’t hesitate to reach out!